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1 Small/Mid-Cap Quality Strategy (including FPA Paramount Fund, Inc. and FPA Perennial Fund, Inc.) Investment Policy Statement OVERVIEW Investment Objective and Strategy The primary objective of the FPA Small/Mid-Cap Quality ( SMQ ) investment strategy, FPA Perennial Fund is long-term growth of capital. Current income is a secondary consideration. The FPA Paramount Fund s primary investment objective is a high total investment return, including capital appreciation and income. The strategy strives to invest in superior businesses which earn high returns on capital. We believe that over time the successful operation of these businesses and intelligent redeployment of the cash flow they produce should yield portfolio returns superior to the market. Investment Philosophy Focus on high-return on capital businesses Avoid leveraged balance sheets Emphasize management track record in operating the business and allocating capital Spend time on bottom-up research, not macro analysis Concentrate on small and medium market cap companies Hold concentrated portfolio with low turnover Investment Process Our process is focused on two key areas rigorous security selection and minimizing the risk of loss. First, company identification and selection: Superior returns on invested capital Fortress balance sheet History of superior financial metrics Track record of wise use of cash flows Prefer leading/growing market shares Second, control of risk: Minimize business, balance sheet, and valuation risk Risk control is closely linked to stock selection Financially strong businesses with leading shares should outperform their competitors in the long-run Concentrate on stocks that are out of favor 1

2 Avoid premium P/E ratios 1 Investment Policy Statement Stocks must pass our quality test to be considered. A cheap price alone is not sufficient. IMPLEMENTATION We attempt to provide a consistent and disciplined approach to long-term investing with the goal of achieving a real total return over a three- to five-year market cycle. This is accomplished through focused research and concentration on several key criteria. First and foremost, we emphasize ownership of high-quality businesses. By this we mean firms with histories of earning high returns on capital, and with modest debt levels. These companies have leading market shares and strong managers who have demonstrable track records of wise reinvestment of the businesses cash flows. Although company quality is our principal investment test, the valuation of investments is also an important part of the stock selection process. Our primary measure of value is the price/earnings ratio. We seek companies that are undervalued relative to their long-term earnings power. We refuse to overpay for even the best companies because the high expectations associated with these premium PEs are often disappointed, potentially leading to lowered valuations. We expect that our portfolio will comprise much better than average companies selling at valuations similar to or below the market. This favorable combination results from two factors that involve our time horizon. Refusing to compromise on business quality often means years of waiting before a company s valuation is attractive. This willingness to wait patiently is an important part of our discipline. Related to that point, many other investors view the word differently, often through a short-term lens. For example, their emphasis on quarterly performance versus expectations is at sharp variance to our demand for long-term high absolute profitability. This timing disparity often gives us an opportunity to acquire high quality businesses at surprisingly low valuations. Minimizing risk, especially during treacherous economic or stock market environments, is an important element of our investment process. We seek companies with relatively unleveraged balance sheets, operating in more predictable, less volatile sectors of the economy, with business models we can understand. Our companies leading market shares and high 1 P/E ratio is a valuation ratio of a company's current share price compared to its per-share earnings. 2

3 operating margins can help to reduce the volatility of their earnings. Diversified portfolios and modest relative valuations, typically lower than the market, can also contribute to lowering the portfolio s risk profile. Business models we would avoid include those with excessive concentration of product, customer, suppliers, or market. Instead, we are attracted to companies with strong worldwide franchises, leading market shares, low-cost production, diverse products and customers, and a technology edge. We are convinced that the unleveraged companies earning high returns on capital that we strive to include in our portfolio, can often benefit from an adverse economic environment. With balance sheet cash supplemented by operating cash flow, these businesses can maintain spending on marketing and product development, and still retain the financial capacity to make strategic acquisitions of weakened competitors at fire-sale valuations. We believe the most important contributor to the long-term investment performance of the companies we own is their ability to grow earnings, not changes in valuation (higher P/E ratios). Because we believe growth is driven by earning high returns on capital and successful reinvestment of cash flow, it is necessary to own most of our portfolio securities for at least a full business cycle in order for each company s value to be fully recognized by the market. Accordingly, annual portfolio turnover has been very low, averaging about 10-15% over the past five years. We recognize there can be a conflict between our very long investment time horizon and a strong value discipline in managing the portfolio. We are willing to hold portfolio securities at valuations higher than we require for an initial purchase. Stock prices fluctuate in the short term, but we believe that most of our portfolio s long-term returns come from the operation of the business. Companies that earn high returns on capital and can reinvest their cash flow to produce similar returns are very valuable. With our long time horizon, we are reluctant to discard one of these gems in which we have confidence in response to short-term volatility. Costs associated with trading also should not be underestimated. We believe the time investment needed to exploit short-term price movements could be better spent analyzing business fundamentals. Naturally, if a position becomes significantly overvalued we do not hesitate to trim or eliminate it. We believe that international diversification can yield valuable benefits to shareholders by providing exposure to faster-growing economies than the U.S. and by offsetting the negative impact of a possible secular decline in the dollar. Much of this exposure to foreign business activity is expected to come from purchases of U.S.-based companies with strong worldwide 3

4 franchises. Companies trading primarily on U.S. exchanges will always be potential candidates for inclusion in the portfolio, regardless of domicile; however, we will also purchase foreigndomiciled companies that meet our usual investment criteria and where we believe that differences in accounting, disclosure, culture, management accessibility and trading do not put us at a competitive disadvantage. Our investment process is fundamental and bottom-up, evaluating each company on its own merits. We are not driven by macroeconomic analysis, though we appreciate that changes in the economic environment can be important to most companies prospects. Our portfolio has historically been moderately concentrated, with positions, well diversified across many industries. We feel that this level of portfolio concentration combines more than adequate diversification yet positions are large enough to have a meaningful impact on performance. In the past this portfolio has been mostly comprised of companies with small to medium market capitalizations (up to $10 billion). We view the small- and mid-cap segments of the market as providing better growth opportunities than large cap. We also hope to capitalize on the potential for less efficient pricing in this segment of the market given thinner Wall Street coverage. Cash has generally been the residual of the investment process. What we mean is, we do not target any specific level of cash for the portfolio. Given that we have been successful in identifying enough securities that meet our strict investment criteria, cash has usually comprised a small percent of assets. Conclusion Early in year 2000, at the time we assumed the management of FPA Paramount Fund, we summarized our investment philosophy for shareholders. What we said then is equally valid now, and echoed in the philosophy and process we discussed above: Our emphasis will be on owning high-quality companies those with a history of earning high returns on capital and leading market shares. We seek to minimize risk by insisting on relatively unleveraged balance sheets. We expect the companies we purchase to have a proven track record of intelligent use of cash flow. Our investment ideas will be generated on a fundamental, bottom-up, company-by company basis. We believe that our approach to investing is timeless and it makes as much sense now as it has in the past. Our approach is not dependent on the economic cycle and it is not based on the current fashionable trends in investing. 4

5 We hold to our belief that superior businesses, earning high returns on capital without taking meaningful financial risks, and reinvesting their cash flows wisely, will over time generate attractive returns for our investors. You should consider the Fund s investment objectives, risks, and charges and expenses carefully before you invest. The Prospectus details the Fund's objective and policies, sales charges, and other matters of interest to the prospective investor. Please read this Prospectus carefully before investing. The Prospectus may be obtained by visiting the website at by at toll-free by calling or by contacting the Fund in writing. FPA Paramount Fund Risks Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The Fund can purchase foreign securities, which are subject to interest rate, currency exchange rate, economic and political risks. The securities of smaller, less well-known companies can be more volatile than those of larger companies. Value stocks can perform differently than other types of stocks and can continue to be undervalued by the market for long periods of time. FPA Perennial Fund Risks Investments in mutual funds carry risks and investors may lose principal value. Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The Fund can purchase foreign securities, which are subject to interest rate, currency exchange rate, economic and political risks; this may be enhanced when investing in emerging markets. Small and mid-cap stocks involve greater risks and they can fluctuate in price more than larger company stocks. Groups of stocks, such as value and growth, go in and out of favor which may cause certain funds to underperform other equity funds. The FPA Funds are distributed by UMB Distribution Services, LLC. 803 W. Michigan Street, Milwaukee, WI

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